Financial Leverage: Understanding the Risk Level of Corporations A and B

What is the degree of financial leverage (DFL) and how does it determine the risk level of a corporation? The degree of financial leverage (DFL) is a measure that indicates how a company's earnings are affected by changes in its operating income or EBIT (Earnings Before Interest and Taxes). It helps determine the risk level of a corporation by showing the extent to which fixed operating costs, such as interest payments on debt, affect the company's profitability.

DFL can be calculated using two formulas:

DFL Formula 1:

DFL = EBIT / (EBIT - interest)

This formula shows the ratio of a company's EBIT to the difference between EBIT and interest expenses. A higher DFL indicates that a company is more leveraged and has a higher risk level.

DFL Formula 2:

DFL = % change in net income / % change in EBIT

This formula compares the percentage change in net income to the percentage change in EBIT. It helps assess how sensitive a company's earnings are to changes in operating income.

Now, let's look at Corporations A and B:

Corporation A has a DFL of 1.75, which means that its interest expenses represent approximately 43% of its EBIT. This indicates that Corporation A is less leveraged and has a lower risk level compared to Corporation B.

On the other hand, Corporation B has a DFL of 83, implying that its interest expenses make up around 98.8% of its EBIT. This high DFL suggests that Corporation B is heavily leveraged and carries a higher risk level than Corporation A.

In conclusion, Corporation B is at a much higher risk level than Corporation A due to its extremely high degree of financial leverage. It is important for investors to consider DFL when assessing the riskiness of an investment in a company.

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